Are ‘B’ buildings poised for a rebound?

The St. Paul central business district has the biggest battle ahead with more than one-fourth of all its Class B office space currently vacant. (File photo: Bill Klotz)

The beleaguered B office market has struggled to climb out of the steep real estate recession. This could be a year when that momentum finally begins to shift in favor of B buildings.

“I think the B market is poised for some growth in 2013, primarily because the A market has seen quite a bit of absorption over the last few years, and in many submarkets, Class A landlords are beginning to increase rental rates and decrease concessions,” says Mike Salmen, a partner at Transwestern in Minneapolis.

B buildings saw vacancies grow as tenants clamored for discounted rates and offers of free rent in newer buildings that also came with better amenities ranging from on-site food service to heated parking. In fact, the Class B office market is reporting the highest vacancy rate in the metro at 21.1 percent, which is significantly higher than the 12.6 percent vacancy in Class A and even edging ahead of the 20.4 percent vacancy in Class C space, according to a year-end report released by Transwestern.

That “flight to quality” scenario is typical in any real estate downturn as tenants seize opportunities to upgrade their real estate at little or no extra cost. But, as excess space continues to disappear among top-notch buildings, the pendulum may be getting ready to swing back in favor of B buildings.

Class B landlords are poised to recapture some of those tenants as rents inch higher in newer A buildings. In fact, the Class B market is already showing signs that a rebound is under way. After posting negative absorption in 2011, the Class B sector recorded positive leasing of 174,860 square feet during 2012, according to Transwestern.

For example, Wells Fargo gobbled up a significant chunk of B office space when it agreed to expand its presence at the 20-story Metropoint in St. Louis Park. Wells Fargo renewed its existing 148,000-square-foot lease and also expanded with an additional 330,000 square feet.

Wells Fargo gobbled up a significant chunk of Class B space when it agreed to expand its presence at the 20-story Metropoint building at 600 Highway 169 S. in St. Louis Park. (FILE PHOTO: BILL KLOTZ)

The St. Paul CBD has the biggest battle ahead with more than one-fourth of all its B space currently vacant. Downtown St. Paul was hit hard by the flight to quality phenom where major tenants such as AgriBank moved out of 375 Jackson St. and into nearly 80,000 square feet at the Class A Wells Fargo Place.

“Those moves have left behind some big holes,” says Eric Rapp, vice president, brokerage at Colliers International in Minneapolis.

As Class A buildings have culled tenants from B buildings, one would argue that B landlords could turn around and use the same strategy on businesses located in C space. To some extent, that has been the case. But, the C market is a significantly smaller pool. At about 13 million square feet, the C market is less than half the size of the B market, which spans more than 29 million square feet.

Still, some positive trends are emerging in that market that could benefit B landlords. For instance, large blocks of contiguous space are disappearing in the A buildings.

“I think you are going to see rates going up in the A and limited space available, which is going to push tenants into B space for one of those two reasons,” says Rapp. “Either they are priced out of A, or the space just isn’t there.”

Landlords need to reinvest

B owners have responded to market competition by reducing rents and offering concessions to fill empty space. Yet the economic downturn made it difficult for cash-strapped owners to reinvest in their properties in recent years. Although, to some degree, that problem was widespread, Class B owners were especially hard hit. Many landlords have not had the capital to invest in improvements to common areas and tenant spaces.

“B and C buildings have not been as well invested in,” says Scott M. Tankenoff, managing partner at Hillcrest Development LLP in Minneapolis.

Those buildings that have been invested in — not to make them fancy — but just to keep them fresh, current and provide a good value for tenants, have done a better job of attracting tenants and filling vacancies, he adds.

Some of the B properties also were working through distressed situations and had trouble doing deals because they were going through the foreclosure process. Now that some of those properties have worked through distressed situation, either with new ownership or recapitalization, they are in a better position to court new tenants.

Landlords within the B sector will face more pressure to put money into their properties this year to remain competitive and attract tenants.

“There are a lot of people with their head in the sand waiting for things to get better,” says Tankenoff. “Those owners that are going to be effective this year will need to be proactive and invest in their properties today.”

Hillcrest is certainly not waiting for a “trickle-down effect” to boost occupancies at its B and C office buildings throughout the Twin Cities. The company has continued to invest to keep properties well maintained and tenant spaces fresh and has paid brokerage fees that are commensurate with the market.

Hillcrest is in the midst of major repositioning its Pentagon Park property in Edina. The company acquired the 38-acre property last year. The property has 720,000 square feet of gross office space that is currently about 70 percent vacant. The immediate goal is to stabilize 300,000 to 350,000 square feet for a range of uses from B to C+ space.

In addition to making key improvements that bring the buildings up to code, Hillcrest will be making needed upgrades to common areas, restrooms and tenant spaces. In some portions of the space, the company plans to create more interesting, edgy space with exposed ceilings and open formats.

“Companies want to go where there is a winner — where owners believe in something and are investing in their properties,” says Tankenoff. “That has not been happening in the last few years.”